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Banks Do the Trades They Want to Do

You give Citigroup Inc. $1,000, when Amazon.com’s stock is at $1,339.60.

At the end of each quarter for the next three years, Citi looks at Amazon’s stock price. If it’s at or below $1,339.60, Citi sends you $25 and the trade continues. If it’s above $1,339.60, Citi sends you back your $1,000 and the trade is over.

At the end of the three years, Citi looks at Amazon’s stock price. If it’s above $1,004.70 (75 percent of the initial stock price), then Citi sends you $1,025 and the trade is over. But if it’s below $1,004.70, you eat the full amount of the loss: For instance, if Amazon’s stock price is $803.80 (60 percent of the initial stock price), then you lose 40 percent of your money, and get back only $600. Citi keeps the rest. (You get to keep all the premiums, though.)

It’s not an amazing trade. It’s fine. You won’t become a billionaire doing it. You are more or less selling Citi an “installment put”: Citi pays you $25 (2.5 percent of your money) every three months for three years, and in exchange you give it some insurance against the risk that Amazon’s stock will go down a lot. If Amazon’s stock craters, you lose money and Citi collects on its insurance. If Amazon’s stock drifts down a bit, Citi pays you all the premiums and doesn’t collect, and you make out pretty well. If Amazon’s stock goes up during the three years, then Citi stops paying you, you stop providing the insurance, and you get to keep the premiums you’ve already collected. If it goes up immediately then you keep only the first, 2.5 percent premium, but you also get your money back in three months.

If you think that Amazon’s stock will grow rapidly and continuously for three years, you probably shouldn’t do this trade. I mean, you could, it’s fine: If you’re right, you’ll collect 2.5 percent on your money in three months (10 percent annualized), which is better than keeping it in a savings account. But if that’s what you think then the better trade is just to buy Amazon stock. If Amazon goes up by 20 percent this quarter, then the installment-put-thing returns only 2.5 percent; Amazon stock, meanwhile, returns 20 percent. (If Amazon goes down by 40 percent, both trades kind of lose 40 percent, so it’s not like you avoid that much risk doing the installment-put-thing.) You don’t do the installment-put-thing to bet that Amazon’s stock will go up a lot. You do the installment-put-thing to bet that Amazon’s stock will be relatively flat and you’ll collect some premium.

Anyway back in February, when Amazon’s stock really did close at $1,339.60, Citi offered exactly this trade as a structured note, and sold about $16.3 million worth of it. Amazon’s stock was higher the next day and never looked back. By May 9, the first valuation date, the stock closed at $1,608, up 20 percent; people who bought the structured notes got their money back plus 2.5 percent, while people who bought Amazon stock instead obviously did much better.

The notes—dubbed “auto-callable” because a rise in the stock price contractually triggers their redemption—are often redeemed in less than a year, and sometimes in as little as a month. In many cases the auto-callable provision leads investors to earn scant returns and receive their money back long before the stated term of the investment.

When Citigroup sold $16.3 million of auto-callable notes tied to Amazon.com shares in mid-February, the firm advertised a 10% potential annual coupon for three years. Three months later, Amazon shares were up more than 20%—but the note was called, meaning that investors who purchased it received a total payout of 2.5%. The bank collected 3.5% in fees, according to calculations by Joe Halpern, a former structured-notes trader and chief executive at asset management firm Exceed Investments.

Eh? If you wanted Amazon stock, you could buy Amazon stock. If you wanted this thing, you could buy this thing. I don’t personally know why you’d want this thing, but the thing itself does not strike me as particularly hard to understand or falsely advertised. If you get your money back with 2.5 percent interest in three months, that is a 10 percent annualized return. (And if you wanted the full 10 percent, well, Citi was offering plenty more similar notes in mid-May where you could roll your money.) All of the economic terms of the thing—everything in my summary above—is set out on the first page of the disclosure document. The people who bought this thing got the thing that they bought, and it worked out just fine for them.

Yes sure certainly it was more lucrative for Citi than it was for the customers, but (1) it still worked out fine for the customers, (2) 3.5 percent is sort of in the range of socially acceptable richness for retail structured notes, and (3) of course it was more lucrative for Citi. Retail customers do not walk into their local Citigroup branch and say “I would like to sell you a weird installment put on Amazon stock” as part of a cunning plan to extract value from Citi. If you find yourself selling a weird installment put on Amazon stock to a big bank, that is because the bank wants you to. You don’t need to do any fancy math—you don’t even need to read the one-page summary—to know that the bank will probably do better out of that trade than you will. It was the bank’s idea! It hardly seems like a criticism.

Tokens as securities.

Here are two pieces of extremely unsurprising news. First, “a federal judge has ruled that U.S. securities laws may cover an initial coin offering” in a criminal fraud case against a man charged with promoting dodgy cryptocurrencies. This is unsurprising because the Securities and Exchange Commission has been saying for months, in publicpronouncements and also in enforcement actions, that ICO tokens can be securities, and that most of them are. It is also unsurprising because it is obviously correct. But now at least one federal court has agreed with the SEC on this, which is something.

Second, the SEC brought (and settled) an enforcement action against a thing called “TokenLot LLC, a self-described ‘ICO Superstore,’” charging it with acting as an unregistered broker-dealer. The SEC has, again, been saying for months that ICO tokens can be securities, and that most of them are, and it has freely brought enforcement actions against ICO promoters for conducting unregistered securities offerings, which is illegal. Logically, if that is the law, then people who operate crypto platforms that allow people to buy and sell unregistered ICO security tokens are acting as unregistered broker-dealers (or unregistered securities exchanges), which is also illegal.

This is completely unsurprising as a legal theory, but it is an important extension of the legal risk of ICOs that sell security tokens without registering them: The legal risks are not just for the people doing the ICO (and collecting the proceeds), but also for the people running the trading platforms (and collecting only trading fees). Crypto exchanges and brokers have to diligence whether the tokens they list comply with the securities laws; if they don’t, then the exchanges and brokers are also at risk.

Anyway this is a big week for crypto enforcement. In addition to those two cases, there’s another SEC enforcement action against a crypto hedge-fund manager that “raised more than $3.6 million over a four-month period in late 2017 while falsely claiming that the fund was regulated by the SEC and had filed a registration statement with the agency.” And here is a Financial Industry Regulatory Authority disciplinary action—its first involving crypto—against a guy who allegedly “attempted to lure public investment in his worthless public company, Rocky Mountain Ayre, Inc. (RMTN) by issuing and selling HempCoin – which he publicized as ‘the first minable coin backed by marketable securities,’” a really impressive amount of nonsense in one sentence.

Further afield, the International Monetary Fund told the Marshall Islands to “seriously reconsider” launching its own sovereign cryptocurrency, in a country report finding that “the potential benefits from revenue gains appear considerably smaller than the potential costs arising from economic, reputational, AML/CFT, and governance risks.” The report is fascinating in part because it imagines the Marshalls’ cryptocurrency—the “Sovereign”—as actual currency:

SOV issuance in the currently planned form and in the absence of a monetary policy framework could also result in monetary instability and pose significant challenges to macroeconomic management. The SOV will, by design, be an international currency and subject to large volatility in its exchange rates. The challenges would be amplified by the planned distribution of SOVs to citizens, which would be equivalent to a monetary expansion through “helicopter money.” Depending on the exchange rate of the SOV against the U.S. dollar at the time of distribution, the implied transfer of purchasing power could be significant and require a sizable reduction in other government spending to prevent an unsustainable increase in aggregate demand. And as the SOV can be used to settle debts and taxes, the government and banks could experience adverse balance sheet effects and face U.S. dollar liquidity risks under currency convertibility.

Imagine if an air-drop of a cryptocurrency actually led to “an unsustainable increase in aggregate demand”! I feel like that would be a pretty impressive accomplishment, for a cryptocurrency. Anyway the IMF is also worried about money laundering, cybersecurity, and an assortment of general dodginess.

Also: “Crypto’s 80% Plunge Is Now Worse Than the Dot-Com Crash.” And here’s this guy, who put $120,000 into Bitcoin in November 2017, watched it rapidly turn into $500,000, watched it just as rapidly collapse, “attempted to mitigate his losses by shifting money from bitcoin to an offshoot called Bitcoin Cash and other cryptocurrencies including Ethereum and Ripple,” and ultimately lost 96 percent of his money. My investing advice to you is, don’t have done that.

Mean reversion.

“For Hedge Fund Stars, Being Right in 2008 Proved to Be a Curse” is the headline here, but I don’t buy it. For these hedge fund stars—David Einhorn, John Paulson and Alan Howard—being right in 2008 made them hedge fund stars; more importantly, it made them dynastically wealthy. The problem, or curse if you will, is not that they were right in 2008, but that they’ve subsequently been wrong. This is bad, but not for them, insofar as they remain dynastically wealthy. Sign me up to be cursed like that!

Also it takes a strange model of the world to conclude that they’re wrong now because they were right in 2008, that their former rightness cursed them. (I mean, not that strange: If you invest well and raise too much money, you may exceed the capacity of the strategy that got you there.) A simpler model—not necessarily right, but useful and amusing—is that their rightness or wrongness is random and uncorrelated, and that being wrong now after being right in 2008 is neither a surprise nor an inevitability nor a curse, but just something you’d expect to happen sometimes in a random and uncorrelated world:

The problem with a business based on geniuses who can spot trends is that few remain geniuses forever. “Regression to the mean is a very powerful force in the universe,” says University of Pennsylvania psychologist Philip Tetlock, who studies the track records of professional forecasters.

Olaf Carlson-Wee has crammed the highs and lows of a hedge-fund career into roughly one year—all before his 30th birthday.

He turned $14,502 into a $150 million personal fortune by going all-in on cryptocurrencies right before bitcoin became a household name. His fund, Polychain Capital, earned investors including Silicon Valley heavyweight Andreessen Horowitz a staggering 2,303% last year, after fees—among the best showings for a billion-dollar investment firm in history—drawing comparisons to Wall Street traders such as John Paulson and George Soros.

Yeah look if your strategy is “buy a lot of crypto” that’s going to do well when crypto goes up a lot and badly when it goes down a lot. It seems a little odd to use terms like “one-hit wonder,” or even “hedge fund,” to describe that dynamic.

Short selling, etc.

“Rat in Broth Wipes $190 Million Off Restaurant Chain’s Value” is the unappetizing headline here: Shares of Xiabuxiabu Catering Management, a Chinese public company, lost 12.5 percent of their value in two days after, you know, Rat in Broth. Rat in Broth will do that. (There’s a picture.) But the thing about Rat in Broth is that anyone could put a Rat in Broth, leading at least one person to speculate on Twitter about the possibility that this could be “intentional share price manipulation.” It seems unlikely, but it is not impossible. Law 5B of Insider Trading is “don’t short a restaurant company’s stock and then poison its food,” and while I am unaware of any actual cases of someone doing this, the law was coined in response tosome speculation about Chipotle Mexican Grill Inc.’s food-poisoning cases. (Obviously there is endless speculation about short-seller sabotage of Tesla Inc., but that is also unproven, and so far there are no cases of Rat in Glove Compartment.)

One thing I will say for short sellers is that many of them really do believe their (standard, correct) claims about their role in financial markets: that they make markets more efficient, deflate bubbles, root out fraud and delusion, and generally make the world better with their unpopular and negative activity. They see it as a noble but misunderstood calling.

Obviously you could approach short selling in a totally different way: You could short a perfectly good company and then try to blow up its factories, murder its executives and put rats in its broth. This would be strictly inefficient, not only from a financial-market perspective but also from a product-market one: If this was really how short selling worked, then all our cars would fall apart and all of our broth would have rats in it.

When people worry that short sellers are bad for society, one source of that worry is that unconstrained unscrupulous short sellers have real incentives to do real harm. (Unconstrained unscrupulous long investors are not symmetrically worrying; their main incentive is just to lie to other financial investors, which is bad but better than sabotage etc.) But this worry rarely comes true. For one thing, short sellers are mostly constrained, and there are laws against murder and sabotage and poisoning. But I also tend to think that they’re usually scrupulous: that short sellers get into that business not purely to make money (it is a hard and risky way to make money) but out of a real, and somewhat unusual, commitment to market efficiency and zeal to tell unpopular truths. Putting a rat in the broth would be a betrayal of all of that.

Elsewhere in restaurants, financial markets and fraud, Andrew Ross Sorkin went to the reopened Four Seasons:

“You know, half the people in this place could be prosecuted,” Oliver Stone, the film director, told me with a sense of glee in 2010 as he surveyed the Grill Room.

Crisis retro.

The tenth anniversary of the bankruptcy of Lehman Brothers Inc. is this Saturday, Sept. 15, and to mark the occasion Bloomberg Opinion has organized a Twitter hashtag campaign from today until Saturday. Share your memories of the crisis using the hashtag #WhenLehmanCollapsed; a selection of tweets will be retweeted and featured on Bloomberg's social media accounts.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Matt Levine is a Bloomberg Opinion columnist covering finance. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz, and a clerk for the U.S. Court of Appeals for the 3rd Circuit.